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Compounding boosts long-term investments

But those who understand cyclical businesses should move in and out often than hold stocks for 10-15 years

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Many successful and speculators have written about their methods. Studying gurus and using them as models is useful. But there is a danger in slavish imitation of any investment style. The chela must be prepared to adapt methods to fit specific circumstances.

Take the example of who has made a vast fortune over the last 60 years. He’s created and implemented rules and over the years, he’s explained his thoughts in letters addressing shareholders.

As a student of Benjamin Graham, he learnt the basics of value-investing and securities analysis. But he made quite a few modifications to Graham’s methods. First, he gave more weight to growth. would buy any business that seemed undervalued. Buffett wanted growth prospects as well as cheap valuations. He was prepared to pay a little more for growth.

He also wanted long-term holdings that offered steady compounded returns, rather than quick profits. Graham was more likely to sell and book profits if a holding became overvalued. Buffett would hold through periods of overvaluation and buy again on dips. Buffett tended to focus only on businesses he considered predictable - that is, businesses he understood. Graham didn’t care what the business was, so long as the valuation was low.

Buffett’s key areas of understanding included finance in general, and more specifically insurance, which is one of the most complex businesses around. Despite his oft-quoted view on derivatives as “weapons of financial destruction”, he has no problems with insurance, which means very complex derivatives. He’s also used other derivatives. On occasions, he’s bought debt instruments and hybrids with complex structures.

Other focus areas include FMCG, media, and some other relatively non-cyclical businesses. In the early years, he avoided commodities. He avoided tech businesses. He also avoided diversifying outside the US.

As his asset base grew, he branched out, perhaps because he couldn’t find ways to deploy more cash in businesses he favoured. At various times, he has made investments in energy and silver. He has also diversified outside the US (to Israel among other places) to reduce currency risk. Also, after avoiding technology and IT for many decades, he has, relatively recently, taken stakes in IBM.

So, Buffett is a flexible man. As a young man, he innovated and diverged from Graham’s methods, while using the valuation frameworks Graham pioneered. He was also lucky in that his early career coincided with a period when the US economy grew at a steady pace. He regularly picked outperformers with his bottom-up style. But almost every kind of American business was growing in the 1950s and 1960s so his methods threw up many businesses offering extraordinary returns.

Perhaps the key to Buffett’s success is his insistence on only investing in areas that he understands.

Since later in life, he’s been prepared to look at sectors and investment classes he rejected earlier, this implies that he’s made the effort to understand new businesses and adapt to changed circumstances. He hasn’t stood still in terms of focus. In his case, the superior understanding was originally in sectors that were by and large, non-cyclical and therefore, rewarding for long-term investments. That led to a preference for long-term holdings. Given a choice, any investor should prefer long-term investments because that brings the power of compounding into play.

But what if the investor’s area of understanding happens to be inherently cyclical sectors, where market leadership and financial health changes very often? An investor with a techie focus for example, or an automobile industry expert, may be foolish to think in terms of holding stocks for 10-15 year periods. Leadership in IT changes every 3-5 years and auto manufacturers must reckon with big swings in profitability every so often. Somebody who understands sectors like these will probably want to switch in and out more often than somebody whose focus is non-cyclicals.

Buffett has always been a bottom-up investor. He looks for businesses he understands with growth prospects. He ignores the macro-economy as such. Again, suppose that a bottom-up style led an investor to a series of cyclical plays because the macro economic conditions of the time favoured cyclicals? The investing style would have to be different.

As it happens, with a growth recession, cyclicals aren’t doing well. There’s been a flight to safety with and pharma being favoured. These are classic old-style Buffett plays, except for one thing. They are all highly-valued in comparison to the overall market. How much of a valuation premium should one be prepared to pay for defensive strength and predictability? This is a question to which every investor must seek personal answers.

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